Externalities, Environmental Policy, and Public Goods Externality A benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service.

Externalities and Economic Efficiency Learning Objective 5.1 Externalities and Economic Efficiency The Effect of Externalities Private cost The cost borne by the producer of a good or service. Social cost The total cost of producing a good, including both the private cost and any external cost. Private benefit The benefit received by the consumer of a good or service. Social benefit The total benefit from consuming a good or service, including both the private benefit and any external benefit.

Externalities and Economic Efficiency Learning Objective 5.1 Externalities and Economic Efficiency The Effect of Externalities How a Negative Externality in Production Reduces Economic Efficiency FIGURE 5-1 The Effect of Pollution on Economic Efficiency When there is a negative externality in producing a good or service, too much of the good or service will be produced at market equilibrium.

Externalities and Economic Efficiency Learning Objective 5.1 Externalities and Economic Efficiency The Effect of Externalities How a Positive Externality in Consumption Reduces Economic Efficiency FIGURE 5-2 The Effect of a Positive Externality on Efficiency When there is a positive externality in consuming a good or service, too little of the good or service will be produced at market equilibrium.

Externalities and Economic Efficiency Learning Objective 5.1 Externalities and Economic Efficiency Externalities May Result in Market Failure Market failure A situation in which the market fails to produce the efficient level of output. What Causes Externalities? Property rights The rights individuals or businesses have to the exclusive use of their property, including the right to buy or sell it. Externalities and market failures result from incomplete property rights or from the difficulty of enforcing property rights in certain situations.

Private Solutions to Externalities: The Coase Theorem Ronald Coase of the University of Chicago, winner of the 1991 Nobel Prize in Economics, argued that under some circumstances, private solutions to the problem of externalities will occur. To understand his argument, it is important to recognize that completely eliminating an externality usually is not economically efficient.

Private Solutions to Externalities: The Coase Theorem Learning Objective 5.2 Private Solutions to Externalities: The Coase Theorem The Economically Efficient Level of Pollution Reduction FIGURE 5.3 The Marginal Benefit from Pollution Reduction Should Equal the Marginal Cost

Private Solutions to Externalities: The Coase Theorem Learning Objective 5.2 Private Solutions to Externalities: The Coase Theorem The Basis for Private Solutions to Externalities FIGURE 5.4 The Benefits of Reducing Pollution to the Optimal Level Are Greater Than the Costs Coase emphasized that the benefits from reducing pollution to the optimal level are greater than the costs.

Private Solutions to Externalities: The Coase Theorem Learning Objective 5.2 Private Solutions to Externalities: The Coase Theorem The Coase Theorem Coase theorem The argument of economist Ronald Coase that if transactions costs are low, private bargaining will result in an efficient solution to the problem of externalities. The Problem of Transactions Costs Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. In practice, private solutions to the problem of externalities occur only if the number of parties bargaining is small. all parties to the agreement have full information about the costs and benefits associated with the externality and they are willing to accept a reasonable agreement.

Making the Connection The Fable of the Bees British economist James Meade argued that there were positive externalities in both apple growing and beekeeping. He concluded that unless the government intervened, the market would not supply enough apple trees and beehives. Steven Cheung of the University of Washington showed, however, that government intervention was not necessary because beekeepers and apple growers had long since arrived at private agreements. In Washington State, farmers with fruit orchards had been renting beehives to pollinate their trees since at least as early as 1917, and today honeybees pollinate more than $14 billion worth of crops annually, from blueberries in Maine all the way to almonds in California. Some apple growers and beekeepers make private arrangements to arrive at an economically efficient outcome.

Private Solutions to Externalities: The Coase Theorem Do Property Rights Matter? In bargaining between utilities and the people suffering the effects of their pollution, the victims cannot legally enforce the right of their property not to be damaged. Would it make any difference if the utilities were legally liable? As Coase was the first to point out, the only difference is that the utilities would have an incentive to pay their victims for the right to pollute, or to pollute less if that was cheaper, rather than the victims having to pay the utilities to reduce pollution. Either way, either side would pay to reduce pollution up to the point where the marginal benefit of the last ton of reduction is equal to the marginal cost.

Government Policies to Deal with Externalities Learning Objective 5.3 Government Policies to Deal with Externalities FIGURE 5.5 When There Is a Negative Externality, a Tax Can Bring about the Efficient Level of Output

Solved Problem 5-3 Learning Objective 5.3 Some toilet paper plants discharge bleach into rivers and lakes, causing substantial environmental damage. How could the federal government can use a tax on toilet paper to bring about the efficient level of production?. Using a Tax to Deal with a Negative Externality

Government Policies to Deal with Externalities Learning Objective 5.3 Government Policies to Deal with Externalities FIGURE 5.6 When There Is a Positive Externality, a Subsidy Can Bring about the Efficient Level of Output

Government Policies to Deal with Externalities Learning Objective 5.3 Government Policies to Deal with Externalities Pigovian taxes and subsidies Government taxes and subsidies intended to bring about an efficient level of output in the presence of externalities.

Making the Connection Should the Government Tax Cigarettes and Soda? Governments impose “sin taxes” on certain products. The effect of a tax on soda is shown in the figure.

Command-and-Control versus Market-Based Approaches Command-and-control approach An approach that involves the government imposing quantitative limits on the amount of pollution firms are allowed to emit or requiring firms to install specific pollution control devices. Are Tradable Emissions Allowances Licenses to Pollute? Some environmentalists have criticized tradable emissions allowances, arguing that just as the government should not issue “licenses to pollute.” But this criticism ignores one of the central lessons of economics: Resources are scarce, and trade-offs exist. Resources that are spent on reducing one type of pollution are not available to reduce other types of pollution or for any other use. Because reducing acid rain using tradable emissions allowances has cost utilities $870 million rather than $7.4 billion as originally estimated, society has saved more than $6.5 billion per year.

Making the Connection The Clean Air Act: How a Government Policy Reduced Infant Mortality The benefit of reducing air pollution in 1970 was much higher than the benefit from a proportional reduction in air pollution would be today, when the level of pollution is much lower. In the two years following passage of the Clean Air Act, there was a sharp reduction in air pollution. Infant mortality in 1972 was reduced by an estimated 1,300 deaths.

Government Policies to Deal with Externalities Learning Objective 5.3 Government Policies to Deal with Externalities Command and Control versus Tradable missions Allowances FIGURE 5.7 Estimated Cost of the Acid Rain Program in 2010

Making the Connection Can a Cap-and-Trade System Reduce Global Warming? Although CO2 emissions rose slightly during the first few years of a cap-and-trade plan set up in Europe in 2005, they should decline over time as the number of allowances is reduced.

Four Categories of Goods Rivalry The situation that occurs when one person’s consuming a unit of a good means no one else can consume it. Excludability The situation in which anyone who does not pay for a good cannot consume it. Figure 5.7 Four Categories of Goods Goods and services can be divided into four categories on the basis of whether people can be excluded from consuming them and whether they are rival in consumption. A good or service is rival in consumption if one person consuming a unit of a good means that another person cannot consume that unit.

Four Categories of Goods Learning Objective 5.4 Four Categories of Goods Private good. A good that is both rival and excludable. Public good. A good that is both nonrivalrous and nonexcludable. Free riding Benefiting from a good without paying for it. Quasi-public goods. Goods that are excludable but not rival. Common resource. A good that is rival but not excludable.

Four Categories of Goods Learning Objective 5.4 Four Categories of Goods The Demand for a Public Good FIGURE 5.9 Constructing the Market Demand Curve for a Private Good

Four Categories of Goods Learning Objective 5.4 Four Categories of Goods The Demand for a Public Good FIGURE 5.10 Constructing the Market Demand Curve for a Public Good

Four Categories of Goods Learning Objective 5.4 Four Categories of Goods The Optimal Quantity of a Public Good FIGURE 5.11 The Optimal Quantity of a Public Good

Common Resources Tragedy of the commons The tendency for a common resource to be overused. Figure 5.11 Overuse of a Common Resource For a common resource such as wood from a forest, the efficient level of use, QEfficient, is determined by the intersection of the demand curve—which represents the marginal benefit received by consumers—and S2, which represents the marginal social cost of cutting the wood. Because each individual tree cutter ignores the external cost, the equilibrium quantity of wood cut is QActual, which is greater than the efficient quantity. At the equilibrium level of output, there is a deadweight loss, as shown by the yellow triangle.

Is There a Way Out of the Tragedy of the Commons? The source of the tragedy of the commons is the same as that of negative externalities: lack of clearly defined and enforced property rights. If enforcing property rights is not feasible, two types of solutions to the tragedy of the commons may occur: 1. If the geographic area involved is limited and the number of people involved is small, access to the commons can be restricted through community norms and laws. 2. If the geographic area or the number of people involved is large, legal restrictions through taxes, quotas, and tradable permits on access to the commons are required.